Thursday, September 22, 2016

Revisiting Tom Basso: How Important is Your Entry Really?

Many
aspiring traders focus on setups and entries. I would say 90% of their
time is actually dedicated to perfecting entries. That is one way to
miss the forest for the trees. Back in the 1990’s, Tom Basso and Van
Tharp had already issued research conclusions on the relative
unimportance of entries in producing good trading results. Their “Coin
Flip” study showed that across 10 futures markets, a simple random entry
with a trailing stop made money.

Assuming
they did not cherry pick the situations for the test, is the relative
unimportance of entries still valid now? Does the random entry still
work or have the markets changed? We decided to answer that question
with a research project using current Forex data.

Tom Basso’s Coin Flip Study

In his book Trade Your Way..., Van Tharp explained how he and Tom
Basso came up with their idea to test a trading system using random entries:

"I
was doing a seminar with Tom in 1991. Tom was explaining that the most
important part of his system was his exits and his position-sizing
algorithms. As a result, one member of the audience remarked, 'From what
you are saying it sounds like you could make money consistently with a
random entry as long as you have good exits and size your positions
intelligently'”. – Van Tharp, Trade Your Way...

Here are the very simple rules Tom Basso used to test the viability of a random entry system:

1) Hypothetical $1 Million account →
this is required in order to simulate diversification amongst futures
contracts, withstanding margin requirements and drawdowns.

2)
Select markets that have more of a tendency to trend so at that time,
this meant commodities and futures markets. In particular, the markets
tested were Gold, Silver, US Bonds, Eurodollars, Crude Oil, Soybeans,
Sugar, Deutsche Mark, the Pound and Live Cattle.

3)
The exit is 3X Average True Range (10 day period) subtracted from the
close. The trailing stop can only get closer to the current market
price, not further away.

4) Position sizing strategy: risk 1% of equity per position

5) Selected markets must be liquid (so that trades can be entered and exited immediately with low slippage).

6) Always be in the market (so as soon as one trade closes, another is opened).

We
used these same rules to run simulations in MT4 with the help of our
resident programmer Craig Drury. We tested the six FX Major pairs along
with Gold from January 1st 2014 to June 30th 2016 (except for NZDUSD
which because of data errors, was tested only until the end of February
2016). Effectively, we tested the random entries through trending and
range bound environments over the entire test period. Unfortunately, MT4
doesn’t have a Monte Carlo generator so we had to do all the runs
manually (20 runs) and it was a lengthy process.

Random Entry Trades taken as per Basso’s Rules in EUR/USD coded by Craig Consulting on MT4

Our
findings? We found no significant deviations from the core concept: Tom
Basso’s system’s rules using the Coin Flip entry remain as sturdy today
as they were back in the 1980s/1990s.

An example of the output in Excel —

Tom Basso’s Random Entry is in fact profitable in most cases.

As you can see, the random entry method ends up with a profit in
most cases (and this was a robust finding across all runs). While the
profit factor is also interesting, there were very few trades overall
and the system produced a very low win rate. Van talks about the
psychological part of trading and even with robust statistics at your
disposal, you can see how traders would find it very hard to stomach
this kind of a system in reality.

It was at this point that additional questions and possible complications to the test arose. We asked ourselves: just how random was Basso’s system?

To keep the discussion short & sweet, here are our thoughts:

Truly random entries should be random in both direction and timing.
Being in the market at all times is not really random. Basso’s
“randomness” simply asked the algorithm to be “long or short” randomly
at a given starting date and then randomly picked long or short after
each trade closed. So this means the starting point and initial
conditions were likely very influential in the results.

The markets weren’t randomly selected. Forex and commodities
exhibit autocorrelation (trendiness) just like the futures contracts
used in the original study. This is another bias to Basso’s test as
stocks do not exhibit the same degree of autocorrelation in returns.

The exits weren’t random at all, are they? The rules for exiting
were very clearly defined as to not be random at all. Basso was not
testing a purely random system — and neither did we. So we’re not saying
that it is possible to obtain decent results simply flipping a coin in
the market as to when to get in and flipping a coin as to when to get
out.

In fairness, Basso was not testing for profitability of a system
with completely random entries and exits. Instead, he simply devised a
test to see if exits were much more important than entries. That test
was positive but even then, Van said traders can do a lot better than
using just a random entry — and still not spend most of their effort on
entry refinement. Our initial research results got us wondering about
the possibility of putting additional randomness into the test and
seeing what came out. When we did, we found both confirming results on
some fronts and surprising results on others.

One of the confirming conclusions that will emerge in next week’s
part 2 article of this series is that the exit strategy influences
returns more than the average trader expects. In particular, we used a
trailing stop which is particularly suited to trending markets. When
random entries were paired with trailing stops in range-bound
environments, positions were “chopped up”. In a trending environment,
though, they really “bucked the trend.” The importance of the
environment (or as Van labels it — market type) turned out to be one of
the more surprising results from the tests.

Join us next week for more about the additional research results and the rest of our conclusions.

Editor’s Note, Van added this comment: "One key to
getting the random entry system to work was the 3 times volatility
trailing stop (which I think I remember as 20 days). That kind of stop
meant that positions could go through a lot of chop before a trend
started. If the stop was shortened to 2 times ATR, even with a 200-day
period — it really wouldn’t do it (my guess but I’m not sure). Another
key to the system — it was ALWAYS in the market with the random part
being long or short. And yes, the starting point was important, but I
remember the study using 10 years’ worth of data — so then the starting
point wasn’t that important in the end. I actually thought the system
would have stopped working because the big commodity trends ended so I’m
surprised they
got it to work."

About the Author:
Justin Paolini has 10 years of experience trading FX. He has studied
Van Tharp’s trading principles and incorporates many of those in the weekly blog posts he writes. He currently works for Forex signal provider FX Renew as a trading coach.